Inventory of Economic Cost Concepts

Cost Functions

Total Cost Function:

It represents relationship between a firm's total costs and the total amount of output it
produces in a given time period and reflects the current capabilities of the firm.

Fixed costs

Cost that remain constant as output increases i.e. Admin Expenses, Bills.

Variable costs

It increases as output increases i.e. direct labor, Machine Hours.

Average cost
The average cost describes how the firms average or per-unit-of-output costs vary with the
amount of output it produces. It is given by the formula AC(Q) = TC(Q) / Q

Marginal cost

It refers to the rate of change of total cost with respect to output; may be thought of as the
incremental cost of producing exactly one more unit of output.

Short run

The period of time in which the firm cannot adjust the size of its production facilities (it can
only vary output by varying the quantities of inputs other than the plant size, such as hiring
another shift of workers).

Short-run average cost

Include the annual costs of all relevant variable inputs (labor, materials) as well as fixed cost
(appropriately annualized) of the plant itself.

Long run

When the firm is free to adjust its plant size optimally

Sunk costs
Costs that must be incurred no matter what the decision is and thus cannot be avoided.
ECONOMIC COSTS AND PROFITABILITY

Accounting Cost

Accounting costs are based on the accrual principles and rely on historical costs

Economic Costs

Economic cost of a resource is its value in the best foregone use (opportunity cost).

Total revenue

Indicates how the firm's sales revenues vary as a function of how much output it sells

Marginal revenue

Represents the rate of change in total revenue (TR) that results from the sale of Q additional
units of output

Theory of the firm

A theory of how firms choose their prices and quantities.

Perfect competition

When in a market in which buyers and sellers are so numerous and well informed that all
elements of monopoly are absent and the market price of a commodity is beyond the control
of individual buyers and sellers.

Game theory

The branch of economics concerned with the analysis of optimal decision making when all
decision makers are presumed to be rational, and each is attempting to anticipate the actions
and reactions of its competitors.

Horizontal Boundaries of Firm

Economies of scale

The production process for a specific good or service exhibits economies of scale over
a range of output when average cost (i.e., cost per unit of output) declines over that
range.

Diseconomies of scale

If average cost increases with output, we have diseconomies of scale.

Economies of scope

Firm A produces two products: X and Y and Firm B produces only X When the cost of producing
X is smaller for Firm A than for Firm B, there are economies of scope. Production of Y reduces
the incremental cost of producing X

Tradeoff among technologies

Long run economies of scale due to choice of production technologies

Cube-square rule
As one increases the volume of a vessel (e.g., a tank or a pipe) by a given proportion, the
surface area increases by less than this proportion. (Warehousing Brewing tanks)

Economies of scale in Purchasing

It is less costly to sell to a single buyer (Example: Group insurance is cheaper than individual
insurance). Big buyers will be more price sensitive and may drive hard bargains with the
suppliers.

Economies of scale and scope in Advertising

Large firms have lower cost of reaching a potential customer (First Term). Large firms also
have a better reach (Second Term)

Economies of scale in Research & Development

Economies of scope in R & D; ideas from one project can help another project

Diversification

Many firms operate in several industries and produce a number of different products.
Diversification confers benefits such as increased efficiency or monopoly power. Managers
may diversify because they enjoy running larger firms.

Vertical Boundaries of Firm

Reasons to Buy
Markets firms may have patents or propriety information that makes low cost production
possible. Market firms can achieve econ of scale that in-house units cannot. Market firms are
likely to exploit learning econ

Agency Costs
Agency costs are due to slacking employees and the administrative effort to deter slacking.
When their are joint costs, measuring and rewarding individual unit's performance is difficult.
It is difficult to replicate the incentives faced by market firms

Reasons to Make
Costs imposed by poor coordination. Reluctance of partners to develop and share private
information. Transaction costs that can be provided by performing the task in-house. Each of
the three problems can be traced to difficulties in contracting

Transaction Costs
Cost of using market the market that are saved by centralized direction. Outsourcing entails
costs of negotiating, writing, and enforcing contracts.

Upstream

early stamps in the production process (i.e. timber)

Downstream
later steps in production (i.e. finished goods in showrooms)

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Strategicness of each concept

Total Cost Function:

This concept reflects the current capabilities of firm using factor of production to shows
lowest possible total cost.
Fixed costs
Fixed costs remain relatively constant regardless of the companys level of production or
business activity and these are less relevant to production decisions.

Variable costs
When making production-related decisions, variable costs are more relevant to production
decisions than fixed costs because variable costs are allocated to units of production and
recorded in inventory accounts, such as cost of goods sold.

Average cost
Average cost, especially over the long-term, normalizes the cost per unit of production and
smooth out fluctuations caused by seasonal demand changes or differing levels of production
efficiency.

Marginal cost
From a business owner's perspective, the marginal benefit is the extra profit you make from
producing more goods, while marginal cost is the expense of producing them.

Short run
Firm cannot change or move the production process

Long run
In the long run, firms are able to adjust all costs whereas firms may be a monopoly in the
short-term they may expect competition in the long-term.

Sunk costs
Sunk costs are important for the study of strategy, particularly in analyzing rivalry among
firms, entry and exit decisions from markets, and decisions to adopt new technologies.

Accounting Cost
In assessing the past performance of the firm, in comparing one firm in an industry to another,
or in evaluating the financial strength of a firm, the informed use of accounting statements
and accounting ratio analysis can be illuminating.

Economic Costs
This concept says that the economic cost of deploying resources in a particular activity is
the value of the best foregone alternative use of those resources.

Theory of the firm

This theory governs decision making in a variety of areas including resource allocation,
production technique, pricing adjustments and quantity produced.

Perfect competition
In a perfect competition market, the pricing strategy is simplea firm accepts the market
price. So in perfectly competitive markets generally try to be as efficient as possible so that
their average cost of production is as low as possible, so that they make the largest profits
that they can.

Game theory
Generally attempting to improve your position in a game by strategic moves. A strategic
move is designed to alter other players beliefs and actions to make outcomes of games
more favorable to you.

Horizontal Boundaries of Firm

Economies of scale
Economies of scale can occur for a number of reasons, including specialization efficiencies,
volume negotiating/purchasing benefits, better management of by-products, and other
benefits of size that translate into savings or greater profitability for a large-scale producer
and these all reasons are strategic nature.

Diseconomies of scale
It arises from large scale of the organization, which cause an increase in costs, such as
communication problems, duplication of processes, internal tensions and rivalries,
inconsistency of strategies, procedures and policies and firms must strategically increase their
size.

Economies of scope
Economies of scope is relatively a new approach in business strategy, and is heavily based on
the development of high technology so variety of products can be produced by efficiently
utilizing same operations.

Cube-square rule
This concept states that the physical properties of production often allow firms to expand
capacity without comparable increases in costs which is a strategic need of any firm.
Diversification

Many firms operate in several industries and produce a number of different products.
Diversification confers benefits such as increased efficiency or monopoly power. Managers
may diversify because they enjoy running larger firms.

Vertical Boundaries of Firm

Agency Costs

Financial incentives strategy prevents the agents to keep shareholders interest as the top
priority otherwise agent uses to company's resources for his own benefit.

Transaction Costs

Transaction costs are the costs which are paid other than money price of a product. These
costs may also involve agreements regarding payments in installments, payment for future
deliver, warranties and guarantees for quality and services.

Upstream

Upstream refer to any part of the production process relating to the extraction stages and it
is strategically important to know that where we are falling or where we exist.

Downstream
The downstream process has direct contact with customers through the finished product
and downstream considerations include awareness to local conditions, sensitivity to cross
cultural differences, and comprehensive training efforts.

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Descending Order according to rank

Economies of scale
Economies of scope
Diversification
Upstream
Downstream
Diversification
Cube-square rule
Perfect competition
Economic Costs
Accounting Cost
Marginal cost
Average cost
Variable costs
Sunk costs
Agency Costs
Game theory
Fixed costs